Russia: We Don't Need the West Anymore

Royal Dutch Shell's $7.5 billion sale to Gazprom may have been coerced by the Russian government. Vitaliy Katsenelson looks at the Sakhalin-2 sale and examines the long-term implications if Russia disregards Western investment.

I can't say I was surprised to see that Royal Dutch Shell (NYSE: RDS-A) will be "selling" 50% plus one share of the Sakhalin-2 project to Gazprom for $7.5 billion. Several months ago, the Russian government wanted to take Royal Dutch Shell to court because it was ruining the environment. I suppose when the Russian government referred to the environment, it meant the economic environment, not Mother Nature. The "environmental" issue was very simple: Product sharing agreements (PSAs) with Shell signed by the Russian government were not considered advantageous to Russia -- at least not anymore.

The $7.5 billion question comes to mind: Did Gazprom buy a controlling stake in the Sakhalin-2 project at a fair price? It's hard to say. $7.5 billion is not chump change, but Shell didn't sell a controlling stake in the project -- which, by the way, ensured a replenishment of its dwindling oil reserves for years to come -- of its own free will. You don't have to be a genius to figure out that after that "sale" (I use that term loosely because it assumes willing participants on both sides), the environmental issues will not be issues anymore.

I'll be blunt: The Russian government manipulated its environmental/legal levers to muscle an ownership stake in the project out of Shell, possibly at a significant discount. I understand, though, that it's much easier to be sympathetic to the poor children and elderly people who are supposed to benefit from this oil money, than it is to feel sorry for a multibillion-dollar, impersonal, foreign (Dutch, to be exact) oil company.

It sounds like a Robin Hood act, taking money from the rich and giving it to the poor. And it's certainly not the first time this has happened in Russia. In 1917, on Nov. 7 (still a widely celebrated holiday in Russia), under the leadership of Mr. Lenin, the masses took from the rich and gave to ... themselves. We all know how that story ended. You cannot have government thievery be a part of the free-market system and expect the market to function normally.

The original Sakhalin dealEric Kraus, who runs a Nikitsky Fund, a mutual fund that invests in Russia, pointed out (PDF file) a study done by Alfa Bank Research, showing that the terms of the original Sakhalin PSA signed in the 1990s were unusually advantageous for Shell and its partners. For instance, PSAs are usually signed for 20 years. The Sakhalin deal was signed for 25 years, renewable at five-year increments at Shell's discretion, forever -- a very unusual clause. There were no caps on costs, and only after Shell was firmly in the black would Russia see anything from the project. According to Kraus, these favorable PSA terms are very uncommon. Cost overruns on the project did not help the issue, but anybody who has ever tried to do business in Russia wouldn't be surprised; the country is infested with bribe-hungry bureaucrats who make doing business there prohibitively expensive and inefficient.

From the current perspective of $60-a-barrel oil, it appears that Royal Dutch Shell got a great deal in the original PSA at Russia's expense. However, in the 1990s, when this deal was consummated, oil prices were much, much lower, and thus the breakeven point and risk for the project were a lot higher. Also, at the time, Russia was cash-poor; the country desperately needed foreign investment and the exploration and development know-how that comes with it. Royal Dutch Shell is one of the best in the field, and it was willing to commit billions of dollars. And unlike the sale of one of Shell's best assets to Gazprom (a public company which is 39% owned by -- and managed in the interests of -- the Russian government), nobody forced Russia to sign the original contract in the 1990s.

Who needs the West?Mafia boss Al Capone was sent to jail not for his murderous crimes, but for tax evasion. Similarly, Mr. Putin & Co. went after Shell for "environmental" violations. However, in this case, Shell's crime is its profitability in the face of the Russian government's lust for oil money and control of natural resources. I don't know if the environmental problems were really problems or not. Every time you drill for oil or gas in the middle of a wilderness, "environmental issues" could be found. But few things in Russia are done for the sake of the environment, and this was no exception.

The very transparent act of renegotiating the terms of this contract, which was signed more than a decade ago, abusing the government-controlled legal system, didn't go unnoticed by foreign companies. Interestingly, even if Gazprom had paid more than a fair price for the Sakhalin-2 project, the market perception of the whole affair will still be negative, since Shell was forced into the deal.

This isn't the first time the Russian government has done something that has abridged the law. Using similar tactics, Russia stole (for lack of a better word) oil company Yukos from its shareholders in 2004, sending its largest shareholder to jail, and has been gradually consolidating (deprivatizing) oil resources under the government (Gazprom) wing.

Ironically, the Russian government doesn't care about foreign investment. It's swimming in cash and doesn't feel like it needs the West (or the East -- two partners in the Sakhalin-2 project were Japanese) any longer. However, despite the appearance of economic prosperity, Russia is a one-trick pony. It's blessed with natural resources (i.e., oil, natural gas, steel, timber, etc.), and that pony has been in popular demand for the last three years. Take the high commodity prices away, and Russia is back in the post-Cold War Stone Age: poor infrastructure, marginal rule of law (which is even more apparent now), and corrupt local governments.

So will this commodity pony be in demand forever? Who knows? Predicting commodity prices is very difficult. But may Russia's soul rest in peace if commodity prices take a dip.

Considering the recent deprivatization trends of the energy industry in Russia, oil and natural gas production is likely to face a long-term decline. All governments are ill-equipped to allocate economic resources, and the Russian government is no exception. There's a significant mismatch between the amount of time politicians spend in office and the many-decade payoff of the oil and gas industry's exploration and development expenditures.

Faced with the allocation of Gazprom's abundant cash flows, even a well-intentioned politician has tremendous incentives to divert the funds toward social programs (i.e., paying pensions to retirees, increasing teachers' wages, etc. ...) that have a more apparent, immediate social impact (read: are good for re-election). Funding exploration and development projects that require a tremendous outlay of capital up front and have a payoff decades in the future is a much less popularity-inducing route.

Private enterprises such as foreign oil companies (not covert, government-controlled entities such as Gazprom) have the appropriate time horizons, the needed capital, and the know-how to get the oil and gas out of Russia. Unfortunately, in lieu of recent developments, they'll be committing less capital to Russia rather than more.

After seeing the current developments, CFOs of foreign companies that were contemplating doing business in Russia are increasing the required return on capital assumptions in their models. As the required rate of return goes up, fewer projects become profitable -- and less foreign capital will flow to Russia. Companies that have already invested in Russia -- ExxonMobil (NYSE: XOM) , BP (NYSE: BP) , Conoco Phillips (NYSE: COP) , and others -- are wondering if they'll be the next "environmental" culprits and may be trying to find a graceful way out. Can you blame them?

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